State Of The Single-Tenant Market
Despite slowdown, investors still actively acquire certain single-tenant property types.
Bernard Haddigan

Haddigan

During the last half of 2006 and the first quarter of 2007, sales velocity has decreased in the nation’s single-tenant retail property sector. There has been a clear division in buyer demand for single-tenant assets. The investment market is split based on quality: asset quality, location quality and credit quality. This year, we expect cash-flush institutional investors will continue to seek high-quality properties in prime locations. However, sellers listing less attractive assets will likely have to adjust their expectations when marketing their properties. While cap rates for premium assets offered little spread over the 10-year Treasury yield, cap rates for lower-quality product increased during the second half of 2006.

The cooling housing market and corresponding decline in cash-out refinancing activity are expected to lead to a slower rate of growth in the economy as a whole, and in the retail market specifically. Despite this cooling, there are elements of the economy that should offset some of the effects of the housing market. Employers continue to create jobs, albeit at a slower pace than 1 year ago. Losses in construction and manufacturing positions are being offset by strong growth in white-collar employment sectors. Interest rates declined throughout much of the second half of 2006, and while the Fed is keeping a watchful eye on inflation, rates are expected to remain low or even decline further this year. Wal-Mart’s slowing sales have caused the country’s largest retailer to pull back new-store growth, but other discounters and warehouse stores are expected to continue expansion plans.

Fast Food Remains Strong

Investors continue to pay top dollar for fast-food properties. The median price has increased 5 percent over the past year to $497 per square foot, with cap rates rising approximately 20 basis points to the mid-6 percent range. Sales activity was concentrated in Wendy’s and Taco Bell stores, with both chains experiencing similar levels of sales velocity in 2006 as they did the previous year. Cap rates for fast-food properties started to rise in the second quarter of 2006, including Taco Bell restaurants, where cap rates rose approximately 50 basis points to 7.4 percent.

Late last year, Burger King reported an 82 percent surge in fiscal first quarter profit, driven by higher margins, modest same-store sales growth and successful new restaurant openings. Strong operating results have some traditional burger properties taking aim at the current breakfast leader, McDonald’s. Wendy’s, which completed the sale of its Baja Fresh Mexican Grill chain late last year, is considering entering the breakfast market for the first time, while Burger King is optimistic about future growth linked to a breakfast addition to its value menu. At the end of 2006, fast-food restaurant owners were facing public pressure from the New York City Board of Health, which approved a measure that requires restaurants to phase out nearly all artificial trans fats from their menu items. This ban, as well as other proposed legislation, will likely cause restaurants to implement changes in cooking oils across the country, since the majority of chains utilize a single recipe for most products. This modification could lead to increased costs and lower profit margins.

Investors Cautiously Seek Discount Store Opportunities

The climate for major discount retailers has been mixed as of late. Tough times for Wal-Mart have raised concerns regarding the retail market’s strength in general, although many analysts attribute the company’s recent weakness to poor customer service and the lack of a cohesive business plan. Wal-Mart, which announced its worst same-store sales performance in 10 years in November 2006, will slow store expansion and capital spending growth considerably in 2007. Domestic construction of Wal-Mart stores is expected to be focused almost exclusively on the Supercenter format, which has come under harsh criticism from many local municipalities. Target typically attracts more affluent households than Wal-Mart and has found greater success offering trendier housewares and higher-quality apparel. As a result, Target has reported healthier same-store sales growth of 5.9 percent, and expansion plans include the addition of 75 new stores in 2007, similar to its growth over the past 2 years. Both retailers have made recent efforts to increase pharmacy sales by expanding their respective $4 generic drug plans. During the fourth quarter of 2006, Wal-Mart expanded the program to nearly all of its domestic stores, and Target quickly followed suit by rolling out a comparable generic drug program to all of its stores.

Buyers have cautiously pursued investment opportunities for discount stores. The median price for all big-box stores declined 2 percent in 2006 to $87 per square foot. However, investors are still willing to pay a modest premium for Wal-Mart stores, and prices rose slightly over the past year to $90 per square foot, while cap rates remained unchanged in the mid-6 percent range. Dollar stores are feeling the effects of a cooling economy and increased competition. Dollar General, the largest retailer by number of stores, announced plans to close more than 400 underperforming locations this year, although the company will continue to open new stores. Investor interest in dollar stores has cooled recently. Buyers have become more cautious due to the industry’s slowing sales growth, comparatively poor leasing terms, and lower-quality construction and locations.

Long-Term Outlook Positive for Drug Store Segment

Solid operational performance and favorable demographic shifts support a positive outlook for sustainable long-term growth in the drugstore sector. Walgreens are the most sought-after assets in this property segment, with the median price rising 9 percent over the past year to $393 per square foot. Rising prices have pushed cap rates down approximately 40 basis points from one year ago to the low-6 percent range. Walgreens in prime locations were trading at or below 5 percent in recent years, but rates this low have become increasingly infrequent. The median price for CVS stores rose 6 percent over the past year to $384 per square foot, with cap rates in the mid-6 percent range. Cap rates for drugstore properties have leveled off and even showed a slight upward bump during the last few months of 2006. The top two chains continue to report impressive results during the fourth quarter of 2006; Walgreens reported a year-over-year increase in same-store sales of 9.4 percent, while CVS reported a gain of 8.4 percent.

There are some competitive forces that are worth watching in the drugstore industry. First, drugstore investors will want to monitor the effects of CVS’s purchase of Caremark, which occurred during the second half of 2006. Both parties spoke of synergies and cost savings at the time of the merger, but it has not yet been seen if this will result in greater operating performance. Another emerging trend for drugstores is the attempt of Wal-Mart and Target to increase their presence in the prescription drug market by offering their respective $4 generic drug programs nationwide. Lastly, Rite-Aid shareholders recently voted on a proposal to purchase Brooks and Eckerd drugstores, which would bring their total number of stores to approximately 5,000, making the company a more competitive rival to Walgreens and CVS.

New Concepts Bolster Grocery Stores

Investors are cautiously pursuing supermarket properties, as traditional grocers continue to implement changes to respond to competitive threats brought on by Wal-Mart Supercenter locations and natural and organic retailers. Mainstream grocers, including Kroger and Safeway, are responding to the 7 percent to 9 percent annual growth of the natural and organic food market by expanding current offerings. Additionally, traditional grocers continue to feel the price pressures brought on by Wal-Mart Supercenters. Although this large format is encountering resistance in several markets, Wal-Mart will continue to bring new Supercenters online, albeit at a slower pace than in recent years. In addition, organic grocers are making changes as well. Wild Oats is trying to enhance the shopping experience at its stores by introducing higher-quality cuts of meat and fresher fish. The late-2006 resignation of the conservative Wild Oats CEO has been interpreted as a sign that the company will look to increase its growth plans going forward. As part of its marketing strategy, Wild Oats also announced that it will close its Phoenix-area Henry’s Farmers Market stores, citing increased competition and limited brand awareness.

Elevated competition, coupled with some saturation and declining same-store sales growth, will likely result in an expansion slowdown at organic-leader Whole Foods. During the second half of last year, Albertsons, the formerly independent grocer, was sold to a consortium of retailers and investors. The company is now being sold off in portions regionally, with the sale of another 132 Northern California and Northern Nevada stores to Save Mart expected to close in early 2007. After the completion of the sale to Save Mart, Albertsons, which had operated more than 2,300 stores across the country, will operate only 390 stores.

Although property sales in the single-tenant sector may have slowed compared to last year, many sectors of the industry have promising long-term prospects. Fast food restaurants and the drug store segment are expected to perform well in 2007 and beyond. Since the retail industry is still flush with capital, investors will continue to acquire quality, single-tenant properties with stable cash flow. 

Bernard J. Haddigan, is the senior vice president and managing director of Marcus & Millichap’s National Retail Group. He can be contacted by e-mail at bhaddigan@marcusmillichap.com.


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